The Problems in Housing and the Labor Markets Will Not Go Away Soon

President Obama announced a mortgage plan aimed at giving relief to homeowners that are facing problems with their mortgages.  Yet, this is just putting a finger in a hole in the dike.

The problem is that after fifty years of governmental credit inflation many homeowners are facing the reality that their homes were grossly over-valued and that they assumed too much debt to finance their “American Dream.”

One out of every four or five houses has a mortgage on the property that is greater than the market value of the house.  Many of these homes are now valued at only 75 percent or less of their mortgage value. 

Regardless of a government “solution” to this situation, either through debt relief or a renewed bout of government-induced inflation, the attitudes and expectations of homeowners have changed.  These homeowners have been “burned” and are unlikely to expose themselves to this possibility again in their lifetimes. 

Even if the market stabilizes in the near term and housing prices bottom out, many potential home buyers will be much more financially conservative in the future given the experience that they have just been gone through. 

The reluctance to buy a home will also be affected by the situation in the labor market.   And, here again there is a longer-term problem that will not be resolved in a matter of months. 

One out of every four or five people of employment age are either unemployed, employed in a part time job but would like to be employed full time, or are not seeking employment.  The percentage of working age people in the labor market has recently dropped to a level not seen for several decades. 

With conditions in the labor market so tenuous, people will not have the same resources to purchase housing as they have had in the recent past. 

But, how is this under-employment situation in the labor market going to be resolved in the short-run?

The fundamentalist preacher Paul Krugman cries out for short-run government “solutions” to put people back into the jobs that were in existence at another time.  Krugman writes, “We have become a society in which less-educated men have great difficulty finding jobs with decent wages and good benefits.”  For example, “Adjusted for inflation, entry-level wages of male high school graduates have fallen 23 percent since 1973.” (http://www.nytimes.com/2012/02/10/opinion/krugman-money-and-morals.html?ref=opinion)

Maybe, part of this problem is that the government has emphasized putting high school graduates into what have historically been entry-level jobs, jobs that are shrinking as a proportion of the jobs available due to changes in technology and needed training.  And, what about those that do not graduate from high school…they are in an even less-favorable position. 

Elsewhere in the New York Times, we read that “Rich and Poor Further Apart in Education.” (http://www.nytimes.com/2012/02/10/education/education-gap-grows-between-rich-and-poor-studies-show.html?hp) “Education was historically considered a great equalizer in American society, capable of lifting less advantaged children and improving their chances for success as adults.  But a body of recently published scholarship suggests that the achievement gap between rich and poor children is widening, a development that threatens to dilute education’s leveling effects.”

This is a gap that cannot be overcome quickly.  And, it is a gap that cannot be overcome by national tests and government spending.

  

Since the end of World War II, politicians have generally believed that they could get elected and re-elected by keeping people employed and by helping more and more people become homeowners.  This underlying emphasis has resulted in the fifty years of credit inflation the United States has experienced since the early 1960s. 

People were kept employed by short-term government economic programs that put the unemployed back into the jobs that held previously before becoming unemployed.  And, why should someone going through high school be concerned about employment when they knew that the government would continue to stimulate jobs in heavy manufacturing and industry and keep them employed. 

The government continued to promote these kinds of stimulus programs even though under-employment increased steadily over the past fifty years and the capacity utilization in manufacturing was declining over the same time period. 

The federal homeowner programs and credit inflation created in the housing sector over the same time period created a “piggy bank” for many people not only helping them to own their own home, but also to allow them the ability to borrow more and more money to binge on consumer goods.     

So, we ended up with the “less wealthy” being under-educated and hence not readily employable in the labor markets of the 21^st century and with many of these same people owning homes and over-their-heads in debt. 

  

This is a situation that does not have an easy or ready solution. 

Under-employment can only be resolved over an extended period of time.  The same holds for people with too much debt.  Short-run stimulus is not the answer.  In fact, the emphasis on short-run stimulation has created and further exacerbated the situation. 

A safety net may be necessary for many of the under-employed and overly leveraged.  In fact, the efforts to keep people in “legacy” jobs and to put families in homes to make their life better may have resulted in a whole generation of individuals being excluded from the mainstream.  They are going to need some economic support.

But, the only real solution to the labor market situation is a long run one and it begins with education and the environment that surrounds the culture of education. 

The situation in the housing market will only get better as people lower their expectations and get their balance sheets back in order.  This, too, will take a substantial amount of time because it is related to a major change in expectations.  People, in the future, just cannot expect a “free ride.”      

Housing and the Economic Expansion

The Great Recession is over. Remember, the recession ended in June 2009 getting close to two years ago.

To many, it sure doesn’t feel like it. Since the second quarter of 2009, over the last six quarters, real GDP has grown by 4.5%. The average year-over-year growth rate for the five quarters since the recession ended is 2.3%. This is way below historical experience.

The reason: housing usually leads the economy into a recession, and, housing usually leads the economy out of the recession.

Not so this time.

And, this is why we are in the mess we are in. Housing is not going to rebound any time soon.

For one thing, banks and thrift institutions (what are they?) really don’t want to provide financing for mortgages. They really don’t want to hold mortgages. For another, the mess with Fannie Mae and Freddie Mac is so uncertain and confused and uncomfortable that they want to have as little to do with mortgages as possible.

In order to understand this I had to go through the mortgage process myself last year. I have no problem getting a loan. I went to the bank where I do most of my business and asked about getting a loan. Sure, they said, and arranged a meeting with the mortgage banker they do business with who approved my loan and all of a sudden my mortgage is with Fannie Mae and I am making payments to the mortgage servicing subsidiary of a major bank somewhere far to the west of Philadelphia. Never in my life have I had a mortgage in the hands of Fannie Mae. Oh, well…

This is, to me, the paradigm of the banking industry. Banks, especially smaller banks, don’t want to hold mortgages on their balance sheets. And, this is just what we wanted it. In the late 1960s and early 1970s when I was in Washington, D. C. and we were creating the mortgage-backed security the idea was to get mortgages out of the commercial banks and thrift institutions and into the hands pension funds and insurance companies who needed long-term assets. Then the depository institutions could lend more.

Why did we create the mortgage-backed security? So, politicians could get re-elected. If more families in America could own their own home through things the government did, then they would be more likely to vote back into office the people that were responsible for their owning their own home.

Likewise with lower income housing, after all, the number one job of politicians is to get re-elected.

So, the United States government got into the business of inflating the housing sector so that
more-and-more American families could own their own home.

How successful was this? Well, in the early 1970s, no mortgages were traded on any capital market in the world. Michael Lewis’ incredible book, “Liar’s Poker”, related to the middle- to late-1980s, and was a large part about the market for mortgage-backed securities which had become the largest component of the capital markets. And, as they say, the rest is history.

But, housing was always the fulcrum on which economic cycles turned. The basic reason was that housing construction could easily be started up and stopped and started up again. The longest post-World War II recessions (before the Great Recession) were one year and 4 months in length and there were only two of them. In order to slow down economic growth and fight inflation, the Federal Reserve would raise interest rates and this would cause mortgage lending to slow down or stop for a time. After sufficient time the Federal Reserve would lower rates once again, mortgage lending would pick up and economic growth would expand once more.

Business lending always lagged the movements in mortgage lending.

It seems as if mortgage lending and housing construction has tapped out. The credit inflation of the housing industry of the last sixty years cause sufficient dislocations that it is going to take a while for the United States economy to re-structure so that the housing industry can pick up once again.

Financial institutions are still facing major, major problems related to the housing industry, not counting the major problems relating to commercial real estate. Commercial banks are slowly accepting the fact that they are going to have to buy back many troubled mortgages, especially mortgages that were sold to Fannie Mae and Freddie Mac. Bank of America has paid back a little, but more is expected. JPMorgan Chase also has a large exposure. What is the hole? Standard & Poor’s has estimated that banks will have to buy back around $60 billion in bad mortgage loans which they sold to others. Some estimates place this total as high as $150 billion. (http://dealbook.nytimes.com/2011/02/09/banks-could-face-60-billion-tab-on-bad-loans/?ref=todayspaper)

In addition to this, the latest statistics indicate that more than one in four mortgages outstanding are underwater, that is, these mortgages are on homes that have a market value less than the amount owed on the mortgage. Homeowners facing this situation are still walking away from their obligations. Who picks up the difference? And, housing prices still remain weak in many markets within the nation.

About one in four individuals in America are either unemployed or under-employed. Savings can only go so far in keeping up payments on the home mortgage. And, 30 states have run out of money in their unemployment trust funds and are borrowing from the United State government to cover the shortfall. How long is this going to continue to be covered?

Manufacturing businesses are only running at three-fourths of capacity, up slightly from historical lows. With so much idle capacity, businesses are not interested in purchasing more capital and hiring more workers to create jobs and incomes. Purchasing seems to be very skewed…basics and luxuries…and computers. This is not very encouraging for a near term pickup.

With little or no housing pickup, expectations for a strong business pickup are pretty low. And, the Fed’s QE2 is not going to have a major impact on the reduction in unemployment or under-employment!

People have one way out of this dilemma in the short run. Inflation!

Inflation may not put the people back into a job, but it can cause housing prices to rise and this can buy them out of the underwater situation. Still, commercial banks, I believe, want to have as little to do with holding mortgages as possible. And, if they originate, or get their mortgage banking friends to originate mortgages, who are they going to sell them to?

Even so, all this will just postpone the housing problem until another time, just like we have done for the last sixty years. We just see high levels of under-employment, low levels of capacity utilization, high amounts of inflation, more debt and more debt, and where does this end?

The Great Recession is over. However, the Great Recovery is nowhere in sight.

Housing Still in Cumulative Downward Cycle?

Why would financial institutions want to put home mortgages on their balance sheets right now?

Answer: they really don’t want to add mortgages to their balance sheets.

The consequence is that very tight credit standards exist for mortgages at the present time, a time when credit standards have usually been increasing as the economy comes out of a recession. A Federal Reserve report covering the third quarter of 2010 showed that 13 percent of bank loan officers stated that they were working with tighter requirements. Only 4 percent stated that they were working with easier ones.

Banks, of course, are not issuing non-governmental mortgage-backed securities. In fact, the amount of mortgage-backed securities outstanding has plummeted beginning in 2008. Federal Reserve statistics indicate that privately issued pools of home mortgages fell by $310 billion in 2008, by almost $340 billion in 2009 and have fallen by about $230 billion in 2010.

Agency- and GSE-backed mortgage pools are increasing but at a rate way below previous levels.
In 2008, home mortgages totaled over $11.1 trillion; at the end of the third quarter of 2010, there was only about $10.6 trillion in home mortgages outstanding in the United States, a 4.5 percent drop.

It is apparent that financial institutions do not want to hold mortgages on their own balance sheets and if they cannot securitize them and sell them then they just don’t originate them.

There appears to be two reasons contributing to this behavior. First, delinquencies and foreclosures are still increasing at near record rates. Trying to work out loans that are delinquent and carrying out the process of foreclosure takes time and human resources, resources that could be used to originate mortgages. Second, home owners do not seem to be borrowing if they don’t have to. Mortgage applications have fallen by more than a third from the levels reached in late 2008 and show an almost continuous decline in 2010. Why should home people move if they don’t have to and home prices continue to decline?

Furthermore, Fannie Mae and Freddie Mac have gotten very aggressive demanding that commercial banks buy back defaulted loans if it can be shown that the mortgages Fannie and Freddie acquired were not originated under stated underwriting guidelines. Financial institutions are scared due to the fact that if they have to buy back defaulted loans…it may put them out of business.

Why should the affected banks make any more loans if they might go out of business? Making loans under these circumstances is just a waste of time.

In terms of home prices, Zillow.com has reported that home prices will have dropped by about 7 percent in 2010. In 2011, Fitch Ratings has projected a further 10 percent decline in home prices.

The dynamics of the housing market, therefore, is that falling employment and incomes are still a problem in many sectors of the economy. Banks are not very willing to originate new home mortgages and have tightened requirements to obtain loans. Housing prices fall because the demand for homes has dropped and there is a large inventory of foreclosed properties on the market. This puts more homeowners “under water” with respect to the outstanding loan values they have. And the cycle continues…downward.

Given such a cycle, there is very little incentive for financial institutions to put home mortgages
on their balance sheets.

But, there is another possibility threatening the value of the home mortgages already on the balance sheets of commercial banks.

Fannie Mae and Freddie Mac are reported to be in discussions with people from the Obama administration seeking support for a program to write down loan balances on home mortgages where the borrowers mortgage is greater than the current market price of their homes.

Doing so would help these home owners by “forgiving” the amount of the loan that is underwater. This would reduce the probability of more foreclosures due to a mortgage being underwater and it would also have the effect of reducing loan payments. The “write down” would cost the American taxpayer as the government would have to pay for the amount written down.

Even more scary is the fact that if Fannie Mae and Freddie Mac start to reduce loan amounts to levels that are more consistent with current prices, what pressure would be put upon commercial banks to do exactly the same thing? And, this pressure would seemingly grow as the next Presidential election came nearer.

Commercial banks, both the largest 25 banks in the country and those smaller than these 25 banks, have slightly more than 14 percent of their assets in home mortgages. How much of a hit could these banks absorb and still remain solvent?

Even a little more “write down” in the face of all the other problems that reside on the balance sheets of the banking system would seem to be very troublesome. (See, for example, http://seekingalpha.com/article/241787-the-pending-2011-debt-refinancing-for-commercial-banks.)

The banking industry is fighting such a write down.

The problems existing banks are facing just seem to go on-and-on. Is it any wonder that the banking system, as a whole, is shrinking its loan portfolio? Is it any wonder that federal regulators are continuing to “prop up” the banking system so that these difficulties can be worked out as smoothly as possible? Is it any wonder that the banking system is not contributing to the economic recovery?

Even with some economic recovery taking place, there are still areas of the economy…housing and commercial real estate…that seem to be in on a cumulative downward cycle.

Questions for a Monday Morning

Beginning in 1961 with the inauguration of President John F. Kennedy, the United States government has basically operated from a “Keynesian” economic philosophy. The economists that Kennedy brought into his administration were avowedly Keynesian and the Kennedy tax cuts that followed were developed from a Keynesian model.

This has been a bi-partisan effort and Republicans are as guilty as anyone in terms of the emphasis upon stimulative government budgets. President Richard M. Nixon confessed in the early 1970s that “we are all Keynesians, now!”

Government economic policy was written into legislation beginning with the The Employment Act, Act of Feb. 20, 1946 which was followed by the Humphrey-Hawkins Employment Act, the Full Employment and Balanced Growth Act, enacted in October 1978. Congress enacted laws that required the government to produce economic growth policies that were aimed at high levels of employment.

A growing economy and high levels of employment became a necessary goal of any presidential candidate running for election (“Get the economy growing again,” and “It’s the economy, stupid!”) or for re-election.

And, what was the result?

Since 1960 through 2009 the United States economy has grown at an average annual compound rate of growth of around 3.2%. Economists in the 1960s calculated that full-employment growth in the economy was about 3.2% and so economic policy was targeting a potential for growth in the United States economy of 3.2%.

If, after 50 years, these economists were to look back they might be astounded that the economy grew roughly at what they presumed to be the rate at which the economy could potentially grow during that time period.

Yet, not all is well with the world.

These economists could argue that fiscal policy really worked. The gross federal debt grew at an average annual rate of more than 9% during this 50 year period. Fiscal policy must have worked?

Financial innovation in the United States government was astounding during this period. As Niall Ferguson has claimed in several of his history books that governments have always been the number one innovator in finance historically. The United States government certainly proved this to be true over the last 50 years.

Certainly, credit inflation was the name of the game during this time period as the private sector came to emulate the government sector in terms of creating financial innovation and financial leverage became the necessary means of competition for firms to gain an edge in financial performance.

On the way to the bank, however, certain other things happened…and these raise some serious questions.

During all of this time period, in the United States industrial sector, capacity utilization went from over 90% of capacity to about 75% of capacity. If growth was proceeding at 3.2% a year, how come our industrial base has been used less and less over this period?
Also, the big concern in terms of unemployment was that we reach and sustain a 4% unemployment rate. Yet the unemployment rate has progressively increased and the under-employment rate, hardly different from the unemployment rate in the 1960s, is now above 20%. Why hasn’t the economic stimulus put more people to work?

Housing, which used to be the backbone of the private sector is now primarily the realm of the federal government. Who owns most of the mortgages in the country?

In the 1960s there were over 14,000 commercial banks in the United States. Now, there are less than 8,000 and, in my view, we are going to 4,000 in the next several years.

We had a vibrant sector of thrift institutions in the 1960s. By the end of the 1980s the thrift industry was almost gone. By the end of 2011, the thrift industry will be gone. This was the result of sound fiscal policies?

Income inequality has risen dramatically over the last 50 years. We have found out that the wealthy or the financially savvy can protect themselves during times of inflation and credit inflation. The blue collar worker, the less financially sophisticated, the middle class cannot protect themselves nearly as well during times when hedging or speculation becomes the way to financial wealth. Weren’t the Keynesian policies supposed to help the less well off by keeping them employed?

The “piggy bank” that the middle class and finally the less-well-off were supposed to exploit and protect themselves against inflation and lead them into a better financial future eventually busted. Housing was the “piggy bank” that many were supposed to ride to retirement leisure. But, falling house prices and foreclosures are turning the dream of many into nightmares? Couldn’t credit inflation keep this ball in the air?

There are many other question going around right now. The concern is the validity of the economic model that has been the foundation of our economic policies over the past 50 years. It appears as if we got the economic growth. What happened to all the other benefits we were supposed to receive once we achieved this economic growth?

The World Economy: A Time of Transition

It seems as if “Macro” forces are dominating movements in the financial markets these days. The latest call to attention of this fact is the article by Tom Lauricella and Gregory Zuckerman on the front page of the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704190704575489743387052652.html?mod=wsjproe_hps_TopLeftWhatsNews). The “big” picture appears to be driving things and not the performance of individual investment opportunities.

Specific attention is given to a statistic called “correlation” which measures “the tendency of investments to move together in a consistent way.”

The article reports that in the 2000-2006 period the correlation of stocks in the Standard & Poor’s 500 Index was 27%, on average. However, during the events that led up to the Iraq war, correlations were near 60%. At the height of the financial crisis, October 2008 to February 2009, correlations were around 80%. They were around 80% during the sovereign debt dislocations in Europe earlier this year. In mid-August correlations dropped to 74% and now reside in the 65%-70% range.

When the prices of many or most stocks move together, individual stock picking is not the optimal investment strategy. This is why many investors have been moving to mutual funds that focus more on “macro” issues rather than on individual companies.

One of the most interesting statements in the article was this: “Prior to the financial crisis, such high correlation levels were seen previously only during the Great Depression, according to data compiled by market-strategy firm Empirical Research Partners.”

I pick up on this statement because of my belief that we are going through a tremendous period of transition. The world is changing. And, it is changing in ways that we don’t fully comprehend. As a consequence, individual “bets” are extremely risky, much more risky than “bets” that tend to aggregate outcomes.

The period of the Great Depression represented another period of major transition. During the Great Recession of the 2000s people were constantly referring back to the 1930s for “lessons learned” with respect to monetary and fiscal policies that could be applied to the current situation so as to avoid falling into as deep a hole as occurred at the earlier time.

However, the major lesson we may have to learn from the era of the Great Depression is that economies have to go through transition periods as they move from one kind of societal structure to another. In many ways, the American economy, and much of the rest of the developed world, still operated on an agricultural foundation in the 1920s. Yes, the industrial base was developing, labor unions were coming into existence, and cities were coming to dominate the rural areas but, in many ways, agriculture still dominated economic policy making.

The government in the United States supported and subsidized the agriculture sector in a way that was unsustainable relative to the emerging industrial cities. When this unsustainable effort collapsed, the economy fell apart and the 1930s through the 1940s saw America restructure from a rural society to one where prosperity resided in the cities and suburbs.

During this transition, it was not easy to pick out winning investments because no one really knew what the future was going to look like. Thus, the correlations of stock prices were high because success depended more upon how the whole economy re-structured and, consequently, how the whole economy recovered.

I believe that there are strong parallels in this respect between the current situation and that which existed in the 1930s.

Whereas America supported the farms and farmers in an earlier age because farming was “the American Way,” in the post-World War II period America supported owning a home in or near cities because it was believed that owning a home was, more or less, the right of all Americans.

Now, something else is happening. The industrial base in the United States is deteriorating, capacity utilization is around 75%, underemployment of individuals of working age is around 25%, and income inequality has become quite large. Labor unions are becoming like the dinosaurs, their species is dying. Center cities do not seem to be the wave of the future as they once were seen. And, home ownership for everyone may not fit into the future of society.

The United States government supported and subsidized the housing industry for fifty years, putting GIs into homes after World War II, financing the suburbs, rehabbing the cities, and so forth. Well, the bubble burst, just like it did for the agricultural sector.

What’s next?

That’s the interesting thing about transitions…you never know exactly where they are going to end up.

There are lots of changes taking place. Before the 1930s, the Industrial Age began: the late 19th century was just the spectacular beginning although agricultural still dominated the scene. The late 20th century saw the beginnings of an Information Age even as the cities and industrial concerns remained in the headlines.

What will an Information Age look like? That is still up to the science fiction writers.

What I am sure of is that information will continue to spread and cause changes worldwide that we cannot even imagine at this point in time. Information markets are going to become ubiquitous and innovation with respect to “Information Goods” is going to extend far beyond the field of finance.

But, there are other changes taking place that are going to “rock” the world. One of these is the political makeup of the world. There is the rise of China and the other BRIC nations. Power collected in the G-7 has been transferred to the G-20. The IMF is changing and will have to change a lot more, moving from European and American dominance to include greater roles for South America and Africa. These changes are going to have massive impacts on the way things are going to get done.

Furthermore, the emerging markets seem to be the place to invest these days. The economies of the United States and western Europe are the sluggards as they go through their needed transitions. These emerging nations are now dealing with one another because the allocation of commodities in the world is crucial for the continued progress of these areas. All these movements are “macro” in nature.

As the transition takes place, the “old” is not going to work in the way it used to. Stock investing will be different, at least for a while. The “old” political philosophies are not going to be very effective as we are finding out in the United States and in western Europe. But, this is a part of the whole process. We must adjust and find out what works and what doesn’t work.

Those that try to force things back into the “old” boxes are not going to survive!

Fannie Mae, Freddie Mac and the Future

Earlier this year a friend of mine and his wife got a mortgage on their new home. (As of today, they have only been married three hundred and fifty-three days.) Let me just say that the price of their home is well into the six figures. They borrowed twenty percent of the purchase price. Both of them have established, on their own, a credit rating of at least A and they pay off all of their revolving credit every month.

About two months after signing the mortgage my friend came to see me. He could not believe that his mortgage was now owned by Fannie Mae! Never in his lifetime did he expect to have a mortgage of his owned by this organization!

But, this is a part of modern America. It is a part of the whole effort by government for people to own “things.” Owning “things” in America is good! Monarchs and other royalty owned “things”. The evolution of the wealthy capitalist included owning “things.” It became the right of every American to own “things.”

And, this desire to own “things” played right into the hands of greedy politicians because politicians could promise to deliver “things” to the people that elected them and thereby get elected and re-elected. In the twentieth century, the “thing” of most importance was a home of one’s own. After all, the number one job of a politician is to stay in office! (http://seekingalpha.com/article/219804-wall-street-greed-vs-washington-greed)

Talk about financial innovations. The United States government is one of the most prolific financial innovators the world has ever seen. Just look at the last one hundred years: savings and loan associations, the Federal Home Loan Bank Board, the Federal Savings and Loan Insurance Corporation, the Office of Thrift Supervision, the Federal National Mortgage Association, the Federal Housing Authority, the Department of Housing and Urban Development, the Federal National Mortgage Association, the Government National Mortgage Association, the Mortgage-backed security, and so on and so on.

The surprise is that Fannie Mae and Freddie Mac don’t own more mortgages than they do!

Government programs based on achieving outcomes generally fail. There are two reasons why they fail. First, the goals and objectives of programs focused upon outcomes are generally not based on economics but are based upon achieving desired social consequences. Second, if a program seems to contribute in any way to politicians getting re-elected, more and more resources will be put into that program going forward.

“Popular” programs based on outcomes seem to grow exponentially as each party seeks to “out-do” the other in promising even more to more people. The underlying economics of the situation do not seem to play any role in the cumulative expansion of such programs.

How can people improve things when they tend to hold onto the “old” assumptions? This is a very difficult problem. We see the tip of the iceberg in the column by Andrew Ross Sorkin, “2 Zombies to Tolerate for a While,” in the New York Times (http://www.nytimes.com/2010/08/17/business/17sorkin.html?_r=1&ref=business) where Sorkin discusses what Congress should do about Fannie Mae and Freddie Mac with Congressman Barney Frank. To Frank, Congress has acted as it should have, well maybe a little later than it should have, but things are under control now. The point being: “money is not being lost by anything they (the agencies) are doing now.” The Congressional Budget Office says that taxpayers could absorb almost $400 billion in losses over the next decade, but, to Barney Frank, this is a result of what has happened in the past. Therefore, the agencies just need to be put on a working basis to go forward.

Yet, this doesn’t get at the fundamental issue which has to do with Americans owning “things”. As long as the focus of the government doesn’t change, the problems will not be resolved.

Again, Congress seems to be fighting the last war. As with the financial reform bill that has just been passed by the Congress (http://seekingalpha.com/article/213263-financial-reform-ho-hum), efforts to reform the housing agencies just aim at preventing what has happened over the past ten years or so. It does not deal with the fundamental issue of what it is trying to achieve (the goal itself) and whether or not this goal can be achieved.

However, the world has already changed and will continue to change.

For one, the world is changing at a much faster pace than it did a decade or two ago. Technology, for one, is changing at an ever increasing pace. People do not stay in the same place as long as they did in the past. Families are more divided geographically than ever before and one out of every two marriages ends up in divorce. Small- and mid-sized businesses rise and fall, grow and are sold, and expand and contract. Many people argue that owning “things”, especially “things” that cost a lot of money, will not be as attractive in the future as they have been in the past. The spending (leasing and renting) habits of Americans are changing.

In finance, the environment has also changed over the past fifty years. The whole idea behind the mortgage-backed security was to generate more cash going into the housing market by creating an instrument that pension funds and insurance companies would hold to match their liabilities thereby getting mortgages off the balance sheets of depository institutions, the originators of the mortgages. The idea was that these latter organizations could then create more mortgages.

This effort was based upon a “static” model of how financial intermediaries worked. With the inflation of the 1960s and 1970s, the model for financial intermediaries changed and became more “dynamic” in nature. By the second half of the 1980s, mortgage instruments became the largest component of the capital markets and the volume of trading in this sector was huge. Trading in mortgages became the most spectacular and volatile part of the capital markets.

With the growth in the number of other mortgage instruments, securitization, and derivative instruments, the mortgage finance industry became one of the hottest things around. This was not something the creators of mortgage-backed securities in the late 1960s expected. And, as with other areas experiencing financial innovation, new and more wonderful instruments can still be expected.

Congress continues to work with a “static” model of financial institutions and a perception that people will continue to focus on “things”. Both are wrong!

As a consequence, whatever Congress creates out of Fannie Mae and Freddie Mac, financial incentives will be set up so that people can “game” the system and take advantage of the efforts Congress makes to attain its social goals.

Maybe one day the government will own all the mortgages on all the homes in America. Some people may think that this would be a good thing. On the contrary, it would be just another story of the less well-to-do paying for the pleasures of the more well-to-do.

Who do you think is going to bear the burden of the almost $400 billion cost of Fannie Mae and Freddie Mac the Congressional Budget Office projects? Certainly not the wealthy. Why is it so hard for the people in government to see that the wealthy have enormous resources available to them to protect their incomes and wealth. The less-well-off do not have those resources. Consequently, over time, the burden falls upon the latter even on the programs designed to help them.

No Housing Recovery In Sight

Households, as a group, are gaining ground financially, but are still far below where they were in 2007. This, along with other weaknesses in the economy, is going to continue to contribute to the weakness in the economic recovery now taking place.

One place this weakness is particularly evident is in the housing sector. The recovery of the housing market helped to lead the economy out of every previous recession in the post-World War II period. In the recent experience, this has not been the case, even with special incentive programs created by the federal government to spur along a rebound.

The figure on housing starts in May 2010, an annual rate of 593,000, confirmed this continued weakness.

The recession ended in July 2009, yet housing starts have hovered around a 600,000 unit annual rate ever since. The highest figure recorded during this time period was an annual rate of 659,000 in April of this year, but the pace dropped off once again in May.

At this time, Americans are just not in a position to acquire housing. If we look at the financial position of United States households since the year 2007, according to the Flow of Funds accounts released by the Federal Reserve, the net worth of households has decline by slightly less than $10 trillion. Year-over-year, from the first quarter of 2009 through the first quarter of 2010, household net worth has risen by a little more than $6 trillion, but almost all of this increase has been in the value of equity shares, something that is not a part of the balance sheets of Main Street America. The value of tangible assets, including the value of homes, has fallen by $5 trillion since 2007 and increased only modestly year-over-year. Again, the beneficiary of any gain here has not been Main Street America.

The plight of the American household is captured in the percentage of households owning their own home and who actually have no equity in the home they are living in. David Wessel captures this dilemma in his Wall Street Journal article this morning, “Rethinking Part of the American Dream,” http://online.wsj.com/article/SB10001424052748703513604575310383542102668.html?mod=WSJ_hps_RIGHTTopCarousel_1. He cites data from the Federal Reserve Bank of New York: for example, in San Diego, 55% of households owned their own home, but the fraction of these households that had equity in their homes was between 35% and 39%; in Las Vegas, only 15% to 19% of households had equity in their homes, even though 59% of those households owned their own home. In the cities reported, Boston, Chicago, and Atlanta scored the highest in owners having equity in their own home.

And, with one out of every four or five working age people being under-employed, it is highly unlikely that there will be a stronger recovery in the housing market in the near future.

Ethan Harris of Bank of America Merrill Lynch is quoted as saying “We’re not going to see a real recovery in the housing market until the foreclosure process gets worked out. That’s…a 2012 event.” (http://online.wsj.com/article/SB10001424052748704009804575309692681916212.html?mod=WSJ_WSJ_US_News_5)

Delinquencies on mortgages seem to have leveled out but they still remain at a high level. Also, foreclosures remain at a high level.

The performance of loans that have been restructured remain dismal: see my post “Eventually Debt Must Be Repaid, http://seekingalpha.com/article/210365-eventually-debt-must-be-repaid. Sixty-five to seventy-five percent of the loans restructured in the Treasury’s loan restructuring plan “re-default.”

And, banks continue to stay on the sidelines in terms of making new loans, especially mortgage loans. With one out of every eight commercial banks on the FDIC list of problem banks and many more on the edge, housing is just not going to show much bounce in upcoming months.

Households, according to the Federal Reserve data, are reducing the amount of debt outstanding, but at a relatively slow pace. This is where, I think, it is important to think about how the country is dividing along two lines, between those that are doing quite well, thank you, and those that are really struggling.

As I mentioned, the value of the financial assets of U. S. Households rose by about $5.5 billion last year, most of the increase coming in the market value of equity shares. However, those benefitting from the rise in the value of equities are generally not the ones that own a home with no equity in it. They are generally the people that are still employed and have a sufficient income. Also, they are not the ones that are in debt in a major way.

In my post on debt repayment, I quoted a report by Fitch Ratings Ltd. indicating that the individuals that were in the mortgage re-structuring program were also heavily in debt on credit cards, car loans, and other obligations. People in this second group are the ones that are excessively in debt and have neither the accumulated wealth nor the current income to pay down their debt.

It is this debt that still must be worked off before the recovery can have any bounce to it. Resolving this debt burden will also go a long way to helping the banking system regain its legs.

Consumer spending may increase modestly, housing starts may gain some, but the Americans that are in this second group will not be the ones contributing to these increases until they get their finances back in order and that may take a long time. To see this in another way, check out what is actually being purchased by consumers. Much of it is up-scale, not ordinary “stuff.”

Economic Recovery?

The front page of the New York Times reads, “Why So Glum? Numbers Point to a Recovery.” (http://www.nytimes.com/2010/04/09/business/09norris.html?hp) The economic recovery is at hand, yet, to many, even to many economists, something seems to be missing.

Unemployment remains high, but it is a lagging indicator. Consumer debt remains high and home foreclosures and personal bankruptcies continue to stay near record levels, but these tend to be lagging indicators. State and Local governments are on the edge, apparently faced with becoming the “next Greece.” (For example, this morning see “Los Angeles Faces Threat of Insolvency”, http://online.wsj.com/article/SB20001424052702304830104575172250422355156.html#mod=todays_us_page_one, and “Next ‘Big Crisis’ Is Unfolding in Muni-Bond Market”, http://www.bloomberg.com/apps/news?pid=20601039&sid=aKj_LXH6zUrw.) But, these problems are related to the condition of the consumer and hence will not recover until the consumer recovers. Commercial banks are not lending, small businesses are not getting bank loans, and there are still concerns about the value of bank assets and the impending loan problems.

Floyd Norris, in his New York Times article, speaks about slow economic recoveries and attempts to put the current situation within the context of other post-World War II recessions. Within this context, he argues, the prospects for the current recovery are not that bad. When the economy is turning around, current data tend to be revised as more information becomes available and the recoveries, historically, appear to be “less slow” than they were during the time they were actually being experienced.

I believe that Norris is correct in his interpretation of where the United States economy is at the present time and how the data we are now receiving compares with the data relating to previous
recoveries.

What this misses, as I have tried to present over the past six-to-nine months, is that there are other factors at play in the economic developments of the past fifty years and this has created a situation that is not favorable to a strong economic performance in upcoming years…unless some things change.

One of those changes that are necessary relates to the inflationary bias of our government’s monetary and fiscal policies. As I have mentioned many, many times before, inflation is not helpful over the longer run and, in fact, over the longer run tend to hurt the very people the inflationary bias is aimed to help. The fact that the purchasing power of a dollar has declined by over 80% in the last fifty years has left the American economy is a very weak position. Long-term inflation has had an impact on the economy.

For one, inflation is supposed to help existing manufacturing industries. Yet, we have seen that over the past fifty years, the capacity utilization of United States industry has continuously declined with each peak reached in a subsequent period of economic recovery lying below the level of the previous peak. (See my post “The Trouble with Recovery,” http://seekingalpha.com/article/192713-the-trouble-with-recovery.)

Inflation is supposed to help labor, yet the level of the under-employed has risen almost constantly during the last fifty years. As capacity utilization has declined, the “mainstream” laborer has found him- or her-self less and less trained to do something outside “mainstream” industry. Hence, the growing number of those that don’t “fit” into the twenty-first century industrial structure. It will be very difficult to put these people back-to-work on a full time basis.

The economy of the past fifty years has also relied on the strength of construction, especially the construction of houses. This area has received special attention in that the government has created many, many financially innovative ways to support this industry which has led to an inflation in real estate prices that has out-stripped those in other areas of the economy.

A consequence of this has been that most personal saving over the past fifty years was tied up in the value of a person’s home. People saved by investing in a home and then watching the value of the house continue to appreciate. This appreciation of home prices also allowed their owners the opportunity to borrow against the increased value of the house to maintain higher and higher living standards. Now much of this “wealth” has been destroyed.

And, the inflationary bias has led to a hurricane of financial innovation. The creation of debt and financial innovation thrive in an inflationary environment. The last fifty years has been a treasure-trove for those in the financial industry and the financial innovation that has resulted exceeds that of any period in the history of human-kind. The economy may seem unbalanced with the growth of the finance industries relative to the manufacturing industries, but that is what you get when you have fifty years of consumer and asset price inflation.

The theoretical underpinnings of the policies that have resulted in the inflationary bias of the last fifty years were built on two primary assumptions. The first is that the labor force must be kept employed in order to avoid revolutionary unrest. The second assumption is that foreign exchange rates would be fixed in value. (See my book review: http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.)

The model derived from these assumptions is “short-run” in nature. (Remember Keynes is quoted as saying “In the long run we are all dead.”) Policy making within this paradigm, therefore, focuses upon achieving short-run goals even if the long run consequences, as presented above, are detrimental to the people that are, hopefully being helped. Since the world is a series of short-runs, the problems resulting from previous “short-run solutions” will be offset at a later date. As we have seen, this does not happen.

In addition, since 1971 most of the world has been operating within a regime of floating foreign exchange rates. A country cannot isolate itself from other countries, in terms of the fiscal and monetary policies it follows, without repercussions. In the case of the United States, we have seen during this period of inflationary bias the value of the United States dollar has declined. The two periods in which this was not the case were those of the late 1970s-early 1980s, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System, and the 1990s, when Robert Rubin was an influential member of the Clinton Administration. Overall, however, the value of the United States dollar has declined during this period and is currently substantially lower, relative to other major currencies, than it was in the 1970s.

The policy focus of the United States government must change. To me, Paul Volcker had it right when he argued that “a nation’s exchange rate is the single most important price in its economy.” Consequently, he argued that a government cannot ignore large swings in its exchange rate. A country’s exchange rate reflects how international markets interpret the inflationary stance of the monetary and fiscal policy of a government. In the future, more emphasis must be placed upon this price in making policy decisions for the United States no longer dominates the world the way it did in the past.

Second, the policy focus of the United States government must move away from employment in legacy industries. A recent research paper by Dane Stangler and Robert Litan, “Where Will the Jobs Come From?”, published by the Kauffman Foundation, emphasizes that “nearly all” of the jobs created in the United States from 1980-2005 were created in firms less than five years old. By focusing on legacy industries in determining its economic policy, the federal government is just fostering an environment in which under-employment is going to continue to grow. This is not healthy for the future of the American economy, especially as emerging nations around the world are focusing on the future and not the past.

The Mortgage Market and More Plans to Aid Homeowners

There is still no better place to observe the consequences of the credit inflation of the last fifty years than the housing market.

Politically, this is democracy at work. Every wave of political change in the post-World War II period has focused on the housing market and putting “Americans” in their own homes in order that the new majority in Congress can get re-elected.

I was in Washington, D. C. during the time period that the mortgage-backed securities were being designed. The rationale for this innovation? Almost all mortgages were made in local depository institutions at that time. But, insurance companies and pension funds had lots of money to invest in longer term securities. If an instrument could be constructed that would allow local depository institutions to sell their mortgages to these companies that wanted long term investment vehicles then the local depository institutions would still have funds available to make more mortgages and put more “Americans” into their own home. And, the incumbent politicians could show their constituents the role they played in not only helping people acquire a home, but also how this effort helped to stimulate the local economy through additional home building. This surely would help the incumbents to get re-elected.

Economically this effort seemed to be sound because it would provide for an almost continued stimulus to the economy, spurring on economic growth and raising employment. A little “inflationary bias” along with this was not bad because almost all the economic models used at this time period showed a positive relationship between inflation and higher levels of employment. Inflation was good for the country!

And, these basic efforts were supplemented by the activities at the Department of Housing and Urban Development, the Federal National Mortgage Association (Fannie Mae) along with the creation of Freddie Mac and Ginny Mae and the work of the Federal Housing Authority, the Federal Home Loan Bank System, and other initiatives forthcoming from both presidential administrations and the Congress. Who could be opposed to such a worthwhile idea?

What we see is that maybe inflation was not all it was said to be. Maybe inflation, in the longer run, can actually be harmful to many of the people it was supposed to help. Maybe one of the “lessons learned” from application of the economic philosophy that dominated Washington in the last fifty years is that you can’t artificially “force” people into situations that are not fundamentally sound on an economic basis.

The efforts of the federal government over the last fifty years or so culminated in the Greenspan/Bernanke credit inflation of the 2000s. The United States experienced a housing bubble during this time period that really capped off the government’s effort to promote homeownership. Asset prices were artificially “forced” to rise further and further. And, as we saw, in the longer run the run-up in housing prices was unsustainable. So the bubble popped!

The consequence? The New York Times reports that “About 11 million households, or a fifth of those with mortgages” are underwater (http://www.nytimes.com/2010/03/26/business/26housing.html?hp). One in five homeowners with a mortgage faces a mortgage that is larger in value than the market price of their home! In addition, many of these homeowners have lots and lots of other debts which they assumed in the Greenspan/Bernanke period of credit inflation. Thus, the default or bankruptcy problem does not exist just in the mortgage area.

Inflation, in the longer run, does not help the lower income brackets and it does not help the middle class. Most people cannot protect themselves against inflation, as can the wealthier classes in society, and the tendency is for those that are not of the wealthy classes to “stretch” their budgets, especially during periods of inflation, to acquire more than they can comfortably carry, financially. Furthermore, as we have seen, inflation tends to increase those that are underemployed in the economy as well as those that are unemployed. When the music stops, the family budget problems extend beyond just paying a mortgage.

This is the dilemma faced by the government in attempting to create a program that will prevent or slowdown defaults and foreclosures. It is not just the fact that the homeowner is underwater. The problem is that the mortgagee is over-extended in other areas and has a real cash flow problem.

The initial effort to provide relief to these troubled borrowers was to reduce interest payments that would reduce monthly mortgage payments. Over the past 12 months over 50% of all mortgages modified in this way defaulted, according to a report just released by the Comptroller of the Currency and the Office of Thrift Supervision. Mortgages that are at least 30 days late climbed to about 58% over the last twelve months. This seems to be evidence that the problem is more than just one of meeting mortgage payments. (See http://www.bloomberg.com/apps/news?pid=20601010&sid=aVYxPZ56vjys.)

The next effort, promised to be released by the White House today, will focus more on writing down the value of mortgages. It is expected that this will prove to be more beneficial to homeowners because it will result in a greater reduction in monthly payments and will reduce the psychological effect of having to pay off something that is larger than the underlying value of the asset it is financing. Another portion of the effort will be to have the F. H. A. insure mortgages that are re-written with lower loan balances, a risky effort for a tax-payer supported institution that is already facing financial difficulties.

There are several problems associated with such a program. First, if financial institutions re-write or re-finance underwater mortgages, the issue becomes one of the solvency of the underwriter. Almost one in eight banks in the United States is either on the problem list of the FDIC or near to being on this list. Can these banks afford to be forced to write off these losses in the near term?

Analysts argue that one of the things the initial effort did (the effort to reduce interest rates) is that it just “spread out” the banks having to deal with foreclosures and capital write-downs over several years. This, at least, allowed the banks to slow down the write-off process allowing them to continue to “stay alive” while they worked out their loan problems. This new program threatens these banks: the losses on these loans would have to be written-off sooner rather than later. Could this accelerate the closing of banks?

Another issue relates to whether or not these problems of “underwater” mortgages are connected to bigger issues than just the foreclosure on houses. It is the case that many of the people that purchased these houses were “stepping up” to a higher living standard and doing so created other payment obligations connected with the higher living standards. Many of the people that are underwater now re-financed in the years before the financial “collapse” and took out a lot of the equity built up in their homes to finance other purchases, perhaps a second home or an addition on the home or some other expenditure that allowed them to “step up.” Without the credit built up through the inflation in their home price they would not have been able to afford the purchases out of their cash flow, even if they continued to remain employed. In these cases the cash flow problem is more than just the difficulty in covering the monthly mortgage payment.

The point is that when a person, a business, or a society attempts to live beyond their means, events will, sooner or later, catch up with them. Inflation incents people to live beyond their means. We are observing the consequences of such behavior in the problems being experienced in the housing market.

Housing and Banking

One of the most disturbing statistics around these days is the status of home owners. The New York Times reported yesterday that it is estimated that one-third of homeowners with a mortgage, or 16 million people, owe more than their homes are worth. Any further drop in home prices, of course, would just enlarge that figure and exacerbate the problem.

This, to me, raises additional concern about the banking industry. My guess is that banks, and other financial institutions, haven’t taken this potential write down onto their balance sheets. For one, they don’t know which individuals in the 16 million are going to default on their mortgage and they don’t know when that is going to happen.

This is, of course, a very important reason for banks not to lend at this time. They are uncertain as to the real condition of their own balance sheets.

The forecast is for a new flood of foreclosed homes to hit the market later this winter and spring.
It has been argued that the best way to assist troubled borrowers is not through reducing the interest rate that has to be paid on the mortgage but by reducing the balance of the mortgage. But, this would mean that in reducing the balance on the mortgages of troubled borrowers, the banks would have to take the loss immediately, something they may not have reserved for, given the fact that they don’t know exactly who is going to need assistance. Many of the plans require the borrower to come in for assistance.

This, however, would reduce the capital that the bank has and threaten the existence of the bank.

And, how many banks are already on the problem bank list of the FDIC? At the end of the third quarter of 2009 the number was 552.

What might be the strategy of the banks?

Well, if banks amend the mortgage agreement to include a lower interest rate they do not have to recognize any loss on the loan at the present time.

But, analysts have said, this just postpones the problem and, in all likelihood, the borrowers will still not be able to pay back their mortgage and so this just slows down the recognition of the failure of the loan.

Right! That is the point!

Banks gain something by adjusting loan rates. They lose by granting principal reductions. By adjusting loan rates, they don’t have to take a charge-off right now. If they grant principal reductions they do have to take the charge-off right now.

Bankers are always more willing to postpone taking charge-offs in the hopes of the environment improving. At least that was my experience in doing bank turnarounds.

Furthermore, the location of the problem we are discussing is in the small- and medium-sized banks in this country.

The big banks, they are running away with huge profits gained from the excessively low interest rates (thank you Fed!) and the large trading profits made in bond and foreign exchange markets. This is not their problem, now.

Also, these small- and medium-sized banks face additional problems down the road in commercial real estate, car loans, and other extensions of credit made during the credit inflation of the 2000s.

It seems to me that Main Street is still not “out-of-the-woods” and that 2010 may be the time when the Main Street “shake-out” really occurs. I hope not, but we need to be aware of this possibility.

The total of 552 troubled banks is really disconcerting. It only seems to me that this number will rise in 2010 before it begins to fall. Best guess is, however, that there will be a lot of bank failures this year.

BERNANKE BUBBLE

I would like to recommend the article in the New York Times this morning by David Leonhardt with the title “If Fed Missed This Bubble, Will It See a New One?” (http://www.nytimes.com/2010/01/06/business/economy/06leonhardt.html?hp)

I would also suggest reading this article along with reading my post from Monday, January 4, “The Bernanke Fed in 2010.” (http://seekingalpha.com/article/180764-the-bernanke-fed-in-2010)

Leonhardt quotes the recent Bernanke speech with regards to “lax regulation”: “The solution, he (Bernanke) said, was ‘better and smarter’ regulation. He never acknowledge that the Fed simply missed the bubble.”

Going further Mr. Leonhardt argues that “This lack of self-criticism is feeding Congressional hostility toward the Fed.” It is also fueling the criticism of other interested parties.

“He (Bernanke) and his colleagues fell victim to the same weakness that bedeviled the engineers of the Challenger space shuttle, the planners of the Vietnam and Iraq Wars, and the airline pilots who have made tragic cockpit errors. They didn’t adequately question their own assumptions.
It’s an entirely human mistake.”

From which Leonhardt concludes: “Which is why it is likely to happen again.”

Need I say more?

Looking For Signs of a Recovery

Amid everything else going on, we still continue to look for signs of a recovery. This weekend I spent some time looking at the investment side of the economy to see if I could pick up any sign of life on the capital spending front. At the end of the weekend, I gave up looking for encouraging information, either in terms of business investment or investment in real estate.

Let’s look at the supply side first, the companies and businesses that supply physical capital, either in terms of real estate or in terms of business equipment. In order to summarize the information on the supply side of the market there seems to be one favorable factor that would encourage the production of investment goods and two that are not encouraging concerning the production of capital goods or real estate.

The positive factor is short term interest rates. The supply of capital goods in the past has been dependent upon the cost of short term funds and right now, of course, short term interest rates are as low as we can ever expect them. If these rates stay at these levels and other factors encouraging investment production improve, we should start to see the economy recover. The word out of the Federal Reserve is that short term interest rates are going to be kept low for an extended period of time and this weekend we heard that these rates may stay low into the year 2011.

The two negative factors relate to the internal cash flow of firms and the terms on which lenders are willing to lend. In terms of internal cash flow, potential suppliers of investment goods are still in a position in which they are trying to de-leverage and actually reduce the amount of debt they have outstanding relative to their internal sources of funds. Thus, there is not much effort to expand production from the suppliers of goods because they have not yet got their balance sheets back in order as of this time.

Lenders, of course, are not lending. If anything, most lenders are still risk adverse and continuing to tighten up on the maturities and terms of any lending they do. As a consequence, we see very little willingness on the side of lenders to encourage the supply of funds to expand.

Therefore, whereas the Federal Reserve is consciously keeping short term interest very low and intends to keep them low for a long period of time, potential suppliers of capital have not seemingly restructured their balance sheets sufficiently to begin to produce again and lenders seem far from willing to take any chance on who they lend to. We are back in the position where bankers, and others, will not lend to someone unless the potential borrower does not need the money.

In terms of the demand side of the market the factors that tend to support investment expenditures all seem to be in the negative range. Long term corporate interest rates have fallen some over the summer and this is encouraging. Moody’s AAA corporate bond rate was at a yearly high in June averaging 5.61% for the month. This rate moderately bounced downward in July but seemed to be rising into the 5.50s toward the end of the month. Moody’s BAA corporate bond rate has declined significantly from March 2009 when it averaged around 8.40% and has fallen to the 7.10% range toward the close of July.

The decline in corporate rates has been encouraging and indicates that the financial market’s taste for risk has improved at the expense of longer term Treasury issues whose yields have been rising since March. The question here is whether there will be a continued rise in Treasury bond rates over the next 12 months or so. If Treasury interest rates continue to rise, as I believe they will, this will put a floor under corporate rates, one that will tend to rise as longer term rates rise in general. And, with the spread between AAA and BAA securities around 150-160 basis points one cannot see this spread getting much narrower as long term interest rates rise over the next year or so.

Less favorable trends appear to be the lack of growth in cash flows This means that those that want to acquire capital goods or real property still face the need to continue to de-leverage their balance sheets. This concern can be combined with the fear that many economic units have about the possibility that they could face default or foreclosure in the upcoming twelve month period. There are still a lot of financial issues that must be resolved and this attitude does not produce a lot of optimism on the part of businesses or individuals to extend their own resources into risky investments in the near future.

This attitude coupled with the economic forecasts that the recovery will be tepid at best for the next 12 to 18 months does not do much to create optimism about future profit expectations. Profits have increased but the general consensus is that a large portion of these profits have been achieved either through cost cutting or through trading operations. Neither one of these can be expected to contribute to a general increase in profit expectations for the future since cost cutting can only do so much and trading profits are sporadic and cannot be counted on on a regular basis. The prospect for growing profit expectations is not strong presently. Confidence can change rapidly, but it appears that it will remain relatively low for the near term.

There are some firms and some industries that are producing solid profits and can be expected to generate profits going forward. How much they will stimulate the sectors that are not performing well and how much they will contribute to a growing optimism concerning the future performance of the economy is anybody’s guess right now. These companies continue to look for an uptick in their business in the coming months as well. It is possible that these companies could lead the economy out of the recession, but they don’t seem to be in a mood to over extend themselves or to take on too much more than they are doing at the present time. They are happy to be making profits and intend to do so in the future: but, in a controlled and conservative manner.

The needed conditions for coming out of a recession are not really present at the current time. The Federal Reserve has, of course, have kept interest rates quite low and there has been the favorable movement in longer term, non-Treasury yields which have declined in recent months as financial markets have moved back into securities that are riskier than U. S. Treasuries. In respect to the cost of money, everything is in place for the recovery. The problem of achieving a sustained increase in real investment, either in plant or equipment or in real estate, rests upon the potential borrowers and the possible lenders. Neither seems to be in any shape to begin borrowing or lending in the near term and this shows both on balance sheets and in the market place.

We have observed in the past that “animal spirits” can be revived and they can be revived relatively quickly. Question marks are always present relating to the issues of what is going to set off the animal spirits and when are they going to be set off. We can only keep looking at the major factors that are related to the psychology of economic units and attempt to determine when the direction of the economy is going to change.

At present, there are indications that a recovery is possibly starting to mount. For example, the index of leading economic indicators rose recently for the third month in a row. Still, the dark clouds fail to go away. Unemployment is, of course, still a big concern. And, with unemployment benefits increasingly running out while unemployment continues to grow and with the further prospect of additional credit difficulties in the banking system while bank failures continue to rise, care still must be exercised before one extends ones self by taking on more debt and by committing ones self to the purchase of expensive capital goods. I don’t believe that animal spirits will be on the rise anytime soon.

Households and the Debt Problem

The Federal Reserve released new data on the financial condition of the household sector of the United States. Like other sectors of the economy, the financial condition of this sector has deteriorated over the past year.

The value of household assets dropped about 15% falling from $77.3 trillion to around $65.7 trillion. Most of the decline came from the fall in housing values and in their stock market portfolios.

In terms of household holdings of stocks, the value of the stocks households owned, mutual funds that were held and funds in retirement plans, the loss was $8.5 trillion. That is, the value of stock holdings fell from $20.6 trillion to $12.1 trillion.

Although mortgage credit fell during the year, total household liabilities stayed roughly the same at about $14.2 trillion. This means that debt as a percentage of assets rose from around 18% to 22% during the year (or net worth as a percentage of assets dropped from 82% to 78%).

Mortgage credit at the end of 2008 was $10.5 trillion so that other household liabilities totaled around $3.7 trillion, with consumer credit making up $2.6 trillion of this latter number. Mortgage credit fell during the year, but not because the household sector was trying to get out of mortgage debt. The primary reason for the decline was foreclosures and the reduction in the willingness of financial institutions to lend.

What this means is that households took on increased leverage during the year, not because they wanted to in order to grow their balance sheets, but because of the decrease in the value of their assets and because of the need to borrow due to lower incomes. The increased leverage was a result of the collapse of the mortgage market, in particular, and the economy, in general. The increased leverage just happened—it was not planned.

In order to protect themselves in the face of these changes, households moved assets into cash and cash equivalent accounts. Banks deposits held by households were at about $7.7 trillion at year end.

This is important information for understanding the state of the economy and the contribution the household sector might make toward turning the economy around. The household sector was in free fall in 2008 and was reacting to events, not leading them.

Households took three major shocks last year: first was the decline in housing prices; the second was the rise in unemployment; and the third was the fall in the stock market. Not only was their cash flow significantly hurt, but the value of their assets fell precipitously. They borrowed in an effort to hold on and they became more liquid so as to be prepared for that “rainy day.”

The year 2009 does not look any better than 2008. Housing prices continue to plummet. The stock market has dropped since the first of the year. And, unemployment has ratcheted up. That is, one can assume that the direction observed in the balance sheets of American household in 2008 will continue to be followed this year. Even if the stock market were to stabilize or rise through the rest of the year consumer spending, I believe, will continue to be weak. Even if housing prices stabilize. Even with the implementation of the Obama stimulus plan.

According to the best information we have there are three further shocks looming on the horizon. The first two have to do with the mortgage market: over the next 18 a large amount of Alt-A and Options mortgages are supposed to re-price. Given the weakness in employment that is expected to continue and the lower household incomes, this event could be devastating. And, on top of that credit card delinquencies are rising and these are expected to grow given the financial condition of the household sector.

Consumers will continue to withdraw from the marketplace as they add debt where they can in order to maintain at least a part of their former living standards. Also, consumers will continue to try and become more liquid so that they can be prepared should they need to need cash to tide them over a rough time. Any improvement in the stock market will be met with households selling more stock so as to move the funds into more liquid assets, the rise in the market making it easier for them to get rid of stocks—even at a loss.

And where are the funds going to go that come to households from the Obama recovery plan? My guess is that a good portion of them will go into liquid assets, or into paying down debt. Households are scared right now. They are going to use whatever they have as conservatively as possible. This even goes for those that have some security in their employment condition.

The data that are coming out confirm the strength of the problem that the policy makers face. The United States has a tremendous debt overhang. This debt problem is going to have to be worked off. Economists talk about “the paradox of thrift”, the problem that consumers are not spending at this time and probably will not spend much in the near future, even though if everyone opened up their pocketbooks and spent, everyone would be better off.

This situation is like a “Prisoner’s Dilemma” game. If everyone else increases their spending reducing their savings and, willingly, increasing their debt and I don’t follow their lead, then I will be a lot better off that all these other people. But, if everyone else believes as I do and doesn’t reduce their savings and doesn’t increase their debt, then I end up losing big to everyone else. So, as in the “Prisoner’s Dilemma” everyone defaults to the decision to save more where they can and to pay off their debt. The consequence of this will be that consumer spending will remain weak and much effort will be extended, where possible, to work themselves out of debt.

The overall problem is that there is too much debt outstanding. The policy makers are focusing upon stimulating the economy by increasing spending. If the debt overhang is truly too great, then the stimulus package will only have a small multiplier effect on the economy as households try and get their balance sheets back in some kind of order.

Such behavior will not have much affect on the economy, and it will also not have much affect on the stock market. Government policy makers must direct more attention to resolving this debt problem. It seems to me that this is what the financial markets are trying to tell them. As Citigroup and Bank of America claim they are showing some signs of profitability. As General Electric survives a reduction in its credit rating, meaning that GE Capital has more of a chance to re-structure itself. As General Motors indicates that it has reduced costs sufficiently to rescind the request for another $2 billion from the government in March. And, as other financial institutions seek to repay to TARP money they had received last fall, the stock market rebounds.

It is the debt problem that is the big concern of the financial markets. In my opinion, as long as the government policy makers put their primary focus on stimulating spending, the financial markets—and the economy—will continue to flounder. When they refocus on the more crucial problem they will find that the financial markets will be more supportive of what they are doing.